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The key performance drivers for equity markets this quarter – and a continuation of a trend throughout the year – is the leadership in mega-cap technology companies. Year-to-date, seven companies in the S&P 500 have contributed roughly 75% of the gains. This group includes Apple Inc. (NSD: AAPL), Microsoft Corp. (NSD: MSFT), Nvidia Corp. (NSD: NVDA), Alphabet Inc. (NSD: GOOGL), Amazon Inc. (NSD: AMZN), Meta Platforms Inc. (NSD: META), and Tesla Inc. (NSD: TSLA). These companies have propelled the Nasdaq to a remarkable 32.3% gain through the first half of 2023 in local currency terms. In contrast, the small-cap benchmark Russell 2000 Index is up 8.1% (in U.S. dollar terms) through to the mid-point of 2023.
The equity gains have been narrow and have yet to filter down to smaller companies. The narrow equity market leadership has been driven predominately by multiple expansion. At the beginning of 2023, this group of seven companies traded at an average forward earnings multiple of 28.7 times. Fast forward to today, and these same companies trade at an average forward earnings multiple of 43.0 times – nearly a 50% increase over the six-month period!
The performance differences between small and large companies have continued to push the disconnect in valuation to historically wide levels. The S&P 600 finished the quarter trading at 15.2 times forward earnings, compared with the S&P 500 at 20.1 times – a discount of nearly five times. It is rare to see such a valuation spread. We haven’t seen a gap this wide since the early 2000s when the S&P peaked at the height of the tech bubble.
In the aftermath of the dot-com bust, small caps went on a multi-year run of outperformance. In the six years from 2000 to 2005, small caps outperformed in each year at an average rate of nearly 12% per year.
After a decade of outperformance in large caps (led by tech), time will tell whether the recent month of outperformance in small caps is the start of a trend. What we do know is market leadership evolves.
Think about today’s darling Microsoft. The company is firing on all cylinders with SaaS, the Cloud, and now the prospects of artificial intelligence (AI) powering impressive fundamentals. But with Microsoft trading at 32.3 times earnings today compared with 11.4 times a decade ago, the multiple re-rating to reflect these fundamentals is likely behind us.
While momentum can carry trends to extremes, at some point it breaks, and new leadership takes hold. What has happened in the past doesn’t reflect the future, and the next 10 years will surely look different than the last 10.
At Pender Value Fund, we continue to focus the opportunity set on small- and mid-sized companies where we see a disconnect with the underlying fundamentals of the business. For example, our weight in Canadian equities stood at 48.1% at the end of the quarter, up from 36.3% in June 2022.
David Barr, CFA, is the CEO at PenderFund Capital Management and Portfolio Manager of several Pender funds, including Pender Value Fund. This article first appeared in the Pender commentaries. Used with permission.
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